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May 15, 2012

Krawcheck Weighs In on JPMorgan Debacle

Four questions for bank management could have prevented latest embarrassment, Krawcheck says

“Institutional banking businesses—including trading operations—typically don't have high barriers to entry,” Krawcheck (left) began. “There are few copyrights or patents. Both the talent and customers are extremely mobile. It does require capital to get in, but new capital has historically flowed into the system. When a U.S. financial institution has pulled back or failed, there has almost always been a European bank or a Japanese bank or some other player willing to take over its trading operations or enter the market in its place.”

Because the barriers to entry are low, she wrote, there's usually no good reason why returns in an institutional banking business should stay very high for an extended period. Competition should drive those returns down. As a result, sustained high returns on equity—especially higher returns than competitors are earning—can be a sign of impending trouble.

“They might mean a business is taking outsize risks, or misunderstanding the risks it is taking, or is skirting too close to the regulations,” she wrote. “Not all high-return businesses crash, but variations on the comment ‘In hindsight, the returns were probably too good and too steady’ are all too common in the financial sector.”

She then directed readers to consider the $2 billion loss disclosed last week by JPMorgan Chase. It will almost certainly turn out to have multiple causes, and surely offers multiple lessons. But, from newspaper reports, “it appears to be another high-return financial business gone bad.”

Can anything be done to prevent such reversals, she asks?

“Because of the time constraints they face, boards can only focus on a limited number of issues. Corporate governance has to be one of them, and, in banking, regulation falls not far behind. After that, bank boards tend to spend their time on the problem children, the businesses that aren't doing well. These days there's an enormous amount of time being spent on the mortgage businesses, and now at JPMorgan likely countless hours to come to understand what went wrong at the chief investment office.”

Yet this focus on problem children ignores that “it's the good kids of today who in banking so often turn into the bad kids of tomorrow.” The businesses that typically trip up are the ones that appeared to be great businesses, with much better than middle-of-the-road returns, she noted.

“While it's a fight against human nature, bank boards should allocate some of the time they spend on today's problem children to digging in to understand how the businesses with the highest returns on equity are sustaining them in businesses with low barriers to entry.”

She concluded with a list of questions bank boards should be asking of management:

Why are the returns so good?

What are we doing that's different?

Why are the returns on this better than our competitors'?

Why do we think this is sustainable?

“Spending that time may feel like a luxury given all the have-to-dos that bank boards have,” Krawcheck wrote. “But if you step back in history, it's clear that having done this could have averted any number of debacles.”